Generating enough passive income to cover the cost of living is the holy grail of early retirement. If you have enough passive income, then you’ll have a lot more choices. You can invest all your active income and ramp up the passive income even more. You can donate some of your passive income to a good cause. Or you can even quit your day job to pursue your own interests. However, that level of passive income can be extremely difficult to achieve.
What’s Passive Income?
I’m sure most readers are familiar with the concept of passive income, but let’s take an in depth look anyway. Passive income can be somewhat amorphous. According to the IRS, passive income only comes from two sources: rental activity and business activities that you do not actively participate in. For me, anything other than income from your job(s) is passive income. I know that’s probably too inclusive, but that’s how I see it. So that’s the two extremes and your definition is probably somewhere in the middle.
What are some sources of passive income?
Rentals – Acquiring a property and renting it out is a great way to generate passive income. You get the monthly rent check and usually the property will appreciate over the long term. However, being a landlord can be stressful and take up a lot of your time. The best way to go is to use a property management company, but a good one can be difficult to find. Investing in rental properties can also require a lot of cash so it might not be possible for someone just starting out.
Dividend stocks – Many companies return a percentage of their profit to their investors. You can invest in these companies and enjoy regular dividend payments. Chevron, for example, will send you $4.28/year for every stock you own. I love our dividend stock portfolio because it doesn’t require a lot of maintenance. I still need to review it occasionally to make sure the companies are doing well, but that doesn’t take a lot of time. Investors also need to be aware that the stock market is volatile. Stock price and the dividend can decrease during bad economic years.
Peer to peer lending – You can lend your money to borrowers through peer to peer lending companies like Prosper and Lending Club. The risk of default is pretty high, but the ROI is supposed to make up for that. My peer to peer lending portfolio is not doing that great. The ROI is about 7.8% and I’m not sure if it’s worth the level of risk. If the economy heads south, I’m sure the ROI would sink like a rock.
Business income – It’s hard to be completely passive as a business owner. If you don’t pay attention to your business, usually it will go downhill. I do have a passive online business at Midlife Finance. I hire writers, a VA, and an advertising rep to run the whole site. The site takes only a few minutes of my time per month, but it doesn’t make much money either. I’m sure there are many successful businesses owners out there, though.
Royalties – You can earn royalties from a book, music, photography, art, and many other creative products. I don’t know much about royalties, but I heard the income is pretty small unless your product is extremely popular.
Bonds –You can lend your money to the government or private companies by buying bonds. These institutions then pay you back the principle plus interest. Bonds are generally much more stable than stocks because a bond is a payment of debt. Usually, you will get your money back unless the company goes bankrupted. Bonds are pretty boring, but you need it to balance out your portfolio. When the stock market crashes, bonds usually do well.
Certificate of Deposit – You can buy CDs from your banks and credit unions. Basically, you let the bank use your money during a fixed term (3 months, 6 months, or 1 to 5 years.) CDs are very safe, but the interest rate is pretty low. Withdrawals before maturity rate usually have a hefty penalty attached.
Annuities – An annuity is a type of insurance. You pay the insurance company a lump sum up front and they will send you a monthly check for the rest of your life. Actually, I don’t know much about annuities because I’m not the right age for it. Annuities can have high fees and expenses so you need to shop around to get the right product from a reputable company.
Social Security Benefit – If you work in the US, then you’re paying into the social security program through payroll taxes. Social security benefits include retirement income, disability income, Medicare, and Medicaid. Retirement benefit can begin as early as 62 and the amount is dependent on how much you earned over your working years.
Whew, that’s just some of the more common ways to generate passive income. The problem with passive income is that it generally takes a lot of time and effort to buildup. Supporting your retirement with passive income will be difficult because the rate of return can be quite small. For example, safer high yield dividend stocks can return 3-4% of your investment. Let’s say your monthly expense is extremely low at $2,000/month. To generate that much dividend income, you’d need about $700,000 invested. That’s a lot of money and we haven’t even included tax yet.
Financially, I think the most attractive thing on this list is the rental property. You can leverage your investment and borrow money from the bank to buy properties. The rent can be increased to keep up with inflation so that’s another positive. Eventually, the property will be paid off and you’ll get to keep most of the rent checks. You still need a substantial amount of cash for the down payment and good credit to get a mortgage, though.
Anyway, the point is that it’s quite difficult to build up a substantial passive income unless you have a high salary already. A more realistic goal is probably shooting for having enough passive income to pay 50% of your monthly expense and then fill the gap with active income. Let’s continue with the example above. Instead of investing $700,000, you’d need only half that. Then you can work part time on something you like to generate $1,000/month to cover the rest of the bills. A little active income can go a long way in retirement.
What do you think? Is it possible to fund your retirement with passive income? It’ll definitely be easier once social security kicks in, but that’s no longer early retirement.
Yes, it is possible. See how Sam at Financial Samurai plans to generate $200,000/year from passive income.